USD 2-Year Yield Drops Sharply but on What Exactly?

The value of the United States dollar has experienced a significant decline, with the DXY index nearing a 4% drop on a month-to-date basis. If this trend persists, it could mark the most substantial monthly decrease in the dollar's performance since November of the previous year. My analysis last Friday, I’ve suggested that the magnitude of this movement might begin to diminish, considering that the global conditions are not particularly favourable for currency appreciation. However, the momentum remains strong, driven now by a notable decrease in short-term yields within the United States. The question arises: Is this the beginning of a more prolonged bull-steepening of the U.S. yield curve? If so, it could signal a continued trend of selling the dollar. What triggered this sudden shift in yields?

US02Y

Source: Tradingview

The most pronounced drop in the 2-year U.S. Treasury bond yield occurred after a speech by Fed Governor Waller and just before comments from Fed Governor Bowman were released. Governor Bowman's comments were in line with expectations, as she is known as the most hawkish governor at the Fed and reiterated her belief in the necessity of further interest rate hikes. Governor Waller's comments, however, were more intriguing, particularly during the Q&A session following his speech and around the time of the plunge in the 2-year U.S. Treasury bond yield. He was willing to entertain the scenario of rate cuts, a stance that aligns with his generally hawkish position within the Federal Open Market Committee (FOMC). This can be seen as a preliminary step in the Fed's shift towards lowering rates.

Until now, the standard narrative emphasized that it was too early to discuss rate cuts, with the primary focus on reiterating the "higher for longer" mantra. However, Waller's acknowledgment that "if you see this (lower) inflation continuing for several more months" could lead to a policy rate reduction added a new dimension to the discourse. While these comments may not be groundbreaking, Waller's openness to discussing such a scenario is crucial. Mentioning a potential timeframe of "3 months" in this context might prompt some to consider an earlier-than-anticipated initiation of rate cuts, serving as a key catalyst for the movement in short-term rates.

The market has already incorporated 5 basis points of cuts into the Overnight Index Swap (OIS) curve for the upcoming March FOMC meeting, pushing the probability to over 30%, with a total of 100 basis points of cuts now priced for the next year. Although inflation is expected to continue its decline, and today's Personal Consumption Expenditures (PCE) data showed further contraction, but it remains uncertain how much further easing can be attributed to inflation data alone. For additional rate cut pricing beyond the current levels, a weakening in hard activity data will likely be necessary.

PCE Prices

Source: Finlogix Calendar

My stance in the foreign exchange (FX) market to capitalize on this shift in rates is a short position on USD/JPY. The recent close was the lowest since September, and the persistently short positions may contribute to a further extension of this downward move as these positions are unwound.

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